Government set to become biggest shareholder in top banks as Japanese weigh bid for Morgan Stanley

THE government will launch the biggest rescue of Britain’s high-street banks tomorrow when the UK’s four biggest institutions ask for a £35 billion financial lifeline.

The unprecedented move will make the government the biggest shareholder in at least two banks.

Royal Bank of Scotland (RBS), which has seen its market value fall to below £12 billion, is to ask ministers to underwrite a £15 billion cash call.

Halifax Bank of Scotland (HBOS), Britain’s biggest provider of mortgages, is seeking up to £10 billion.

Lloyds TSB, which is in the process of acquiring HBOS in a rescue merger, wants £7 billion, while Barclays needs £3 billion.

The scale of the fundraising could lead to trading at the London stock market being suspended. This would give time for the market to digest the impact of the moves.

One consequence of the deal might be that Lloyds could renegotiate the terms of the HBOS takeover, although both sides are still keen for the merger to take place.

An economist who declined to be named said: “This is the biggest risk of the UK’s balance sheet ever undertaken. No-one knows the extent of the toxic assets these banks are exposed to.”

Separately, the future of Morgan Stanley, the American investment bank, is also in doubt today following a sharp sell-off of shares and warnings of a possible credit downgrade from Moody’s the ratings agency.

Mitsubishi UFJ Financial Group is reviewing the terms of a $9 billion (£5.3 billion) capital injection into the bank and may launch a takeover. HSBC, Citigroup, JP Morgan and Deutsche Bank are also assessing the situation. Morgan Stanley’s market value has slumped to $13 billion.

The British bank rescue could leave the government owning 70% of HBOS and 50% of RBS. As a result it could take board seats at both companies and exercise control over future dividend payments.

Crisis talks were taking place this weekend between the Treasury, the Financial Services Authority, the Bank of England and heads of the four retail banks. As part of the fundraising it is likely that banks will also have to own up to future losses from their exposure to sub-prime mortgages and other financial instruments.

Mervyn King, the governor of the Bank of England, has told the banks to ask for more than they need. This is to make sure that their capital position is strengthened sufficiently to absorb shocks and to withstand a long recession. Further capital is also available and the Treasury has increased the total amount to £75 billion.

It is thought all parties believe a co-ordinated rescue is the way forward. Final details will be thrashed out tonight.

The way in which the money will be raised has also been simplified. The government may have to underwrite an issue of ordinary shares. This would give pre-emption rights to existing investors, and those shares not taken up will be owned by the government. These could be placed in a new bank reconstruction fund that would hold them until conditions improve.

King had insisted on the recapitalisation of the banks as a condition for other elements of last week’s bailout package, including a doubling of the special liquidity scheme from £100 billion to £200 billion and a new £250 billion guarantee of bank lending.

The Bank of England has also increased the stress test required for banks to prove that they are in a strong capital position. This is called its “core capital ratio” and it has been boosted from six to nine.

Banking sources say the combined loss of capital of the banks as a result of the credit crisis was £150 billion but some of that has already been made up by earlier capital-raising exercises and some will not be needed because the banks will be more constrained in their future lending.

The Bank has also been pushing for early action by the banks on raising capital. “They say there’s no excuse for delay,” said one banking source. “We need to get on with it.” Banks concede that executives will lose their jobs. Among them, Goodwin and his chairman, Sir Tom McKillop.

In addition, Barclays is trying to raise about £3 billion from Middle Eastern sovereign-wealth funds, including the Qatar Investment Authority, as well as Asian investment houses, including Japan’s Sumitomo Mitsui Banking Corporation.

US Treasury secretary Hank Paulson gave a clear indication late on Friday that he would stand behind Morgan Stanley and Goldman Sachs to prevent another collapse on the scale of Lehman Brothers.Both banks were hard hit by last week’s historic stock-market sell-off. Morgan Stanley’s stock dropped almost 60% last week, while Goldman’s fell 29%.

Paulson’s assurances followed the G7’s plans to tackle the economic crisis. “We did not speak to any specific firm today. We spoke about firms that were important and firms that were important systemically,” he said. Questions over continuing liabilities stemming from the collapse of Lehman Brothers, Washington Mutual and the Icelandic banks continue to rumble through the markets.

An auction process on Friday night determined that the collapse of Lehman Brothers will cost providers of credit default swaps an estimated $233 billion payout – which has to be paid in the next two weeks..

While much of the exposure is expected to sit with AIG, the insurance giant that has been partially nationalised, a number of banks are thought to have issued insurance against bank collapses that will now be called upon. Pressure is mounting on the International Accounting Standards Board to abandon its “mark-to-market” accounting principles, which many believe has been one of the key factors in causing the credit crisis.

The rules insist that assets be held on a bank’s book at the most recently traded market price. As the markets took fright from exotic credit derivatives, the prices fell well below what is considered to be their true economic value – leading to bigger than expected paper losses being taken by the banks. As the markets have crashed, the problem has become ever more acute.

On Friday night, America’s chief accounting body, the Financial Accounting Standards Board, revealed that it would suspend the mark-to-market rules to take account of extreme market conditions. Institutions will be able to use their own estimates of an asset’s worth instead. The move follows pressure from the US Securities and Exchange Commission.

In a “position” statement, the board said: “In determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available.”

Questions also persist about the collapse of the Icelandic institutions, and the knock-on effects of their demise. It has emerged that the FSA told the London-based capital-markets business of Kaupthing to move some of its £20m cash pile out of a bank account held with its Icelandic parent company “several months” before the bank collapsed last week.

A senior source at Kaupthing Singer & Friedlander Capital Markets, run by former KBC Peel Hunt boss Tim Cockcroft, said the cash had been moved into four or five UK bank accounts following concerns raised by the regulator.

The news suggests the regulator may have been flagging concerns about Iceland to business customers while local councils and consumers continued to deposit cash with the banks.

A handful of Treasury officials have grown concerned about the potential for conflicts of interest emerging between the advisers working on the bailout deal and the financial implications.

For example, Goldman Sachs, which is advising Royal Bank of Scotland, also has large financial exposures to the bank.

There have been calls within the Treasury for an independent advisory boutique like Blackstone or Greenhill to be appointed to monitor conflicts of interest, but it is understood that these calls have gone unnoticed so far.